Consumption-Based Pricing: Is It A Good Choice For Your SaaS Business?
Since 2017, SaaS companies have seen steady revenue gains with a compound annual growth rate of 22% when adopting consumption-based pricing models—furthermore, 80% of customers who purchase from these companies report better alignment with the value they receive.
Though no one can predict tomorrow’s events, there are a few things we know: software options are plentiful and consumers’ pockets are tight. If you’re a forward-thinking operator, you’re using this time to find the pricing strategy that’s going to keep churn low & margins high.
So, what about taking a page from the playbook of big, successful proponents of consumption-based pricing? JFrog, Snowflake, Google Cloud, and Amazon Web Services (AWS) are a few that have cracked the code to profitability. They are some of the fastest-growing SaaS companies with the highest value, due in part to a consumption-based pricing model.
Based on the research, the verdict is clear: customer preferences are shifting from subscription pricing to consumption-based pricing and the companies that are listening are transitioning some or all of their offerings.
According to Bain, this shift will increase over the next one to three years, with a large majority of the change taking place in the next 12 months! This shift is significant for growth-stage tech founders, CFOs, and CEOs to pay attention to and consider when developing their pricing strategy.
So, is consumption-based pricing the holy grail of pricing strategies? Keep reading to explore this popular pricing model, the different types of consumption-based pricing, its benefits, and how to decide if it’s the right approach for your SaaS business.
What is Consumption-Based Pricing?
What do active users, messages sent, storage space used, and API calls all have in common?
They’re all examples of usage metrics you can price for. Consumption models work off these numbers, providing better alignment between the price paid and the value received by the customer (particularly for growth-stage SaaS companies). Customers are billed by usage instead of a fixed monthly rate, as is standard in subscription models.
Who is consumption-based pricing best for?
Ridesharing platforms, marketing automation platforms, and cloud computing providers are a few of the verticals that are a shoo-in for this pricing strategy. Why? Because they can easily break down their services into measurable units of usage.
To give you more context, let’s take the cloud-based data warehousing solution, Snowflake, as an example: they’re an industry-leading SaaS business known for showcasing the success of consumption pricing. Their pricing structure revolves around the consumption-based metrics of computing usage and data storage.
For computing, Snowflake charges based on the number of credits utilized to execute queries and perform services. The pricing rate for these credits varies depending on the edition of Snowflake (whether standard, enterprise, or business-critical).
As for storage, Snowflake calculates charges based on the volume of bytes stored per month and any data transfer costs incurred while moving data across different regions. The size of compressed files is taken into account to determine the storage expenses associated with an account.
Although three out of five SaaS companies used some form of consumption pricing in 2022, you can’t take it at face value. For example, depending on the business model, pricing per single unit could lead to customers seeing outsized charges for hundreds or thousands of units, which can inevitably impact churn rates. In these scenarios, a more dynamic solution (or just going back to a subscription pricing model) might be a better choice.
Is It Different Than Usage-Based Pricing?
The short answer is: it depends. A consumption-based and usage-based pricing model broadly refers to the same concept with a few minor caveats.
While the terms consumption-based pricing and usage-based pricing can overlap, consumption-based pricing tends to have a broader connotation that encompasses overall usage and consumption, including both the breadth and depth of use. On the other hand, usage-based pricing may place more emphasis on specific actions or features within the overall consumption.
Ultimately, the key concept behind both consumption-based and usage-based pricing is to align the costs with the value or resources consumed by the customer, providing a more flexible and customized pricing structure.
Common Consumption-Based Pricing Models
Within the realm of consumption-based pricing, various models cater to different business needs. Let's explore these models in more detail and understand how they might benefit your business and your customers.
Pay-As-You-Go (PAYG)
The Pay-As-You-Go (PAYG) pricing model is a popular variation of the consumption-based pricing model and is adopted by brands like AWS and Microsoft Azure. In this pricing model, customers are billed based on the actual usage of the SaaS product or service. The more they use the software, the more they pay, and vice versa.
Here’s an example of how it works:
Let’s say you’re the CFO of a project management tool. Under the PAYG model, you would be billing your customers based on the number of active users, the storage space they consume, or the number of projects they manage.
The more a user manages projects on your platform, the more they pay. If they go through a lull, they don’t have to worry about useless expenses. Customers appreciate flexibility and cost control, as they can easily scale their usage up or down based on their needs or budget.
Tiered Pricing
Tiered pricing is another common consumption-based pricing model for SaaS companies. Customers are offered different pricing tiers based on their usage levels or specific features they need. The pricing tiers are typically structured to align with different usage levels or features. Customers can access more functionality, increased usage limits, or enhanced support as they move up to higher tiers - sort of like getting a VIP upgrade at a luxury hotel or backstage passes to your favorite concert. Who doesn’t love perks?
Some examples of SaaS companies that use tiered pricing include Salesforce and HubSpot.
As a Customer Relationship Management (CRM) platform, Salesforce implements tiered pricing based on the functionalities and capabilities provided to users. They offer different editions of their CRM software, such as Essentials, Professional, Enterprise, and Unlimited, with each tier offering additional features and scalability options.
Tiered pricing offers customers transparency, predictability, cost optimization, efficiency, and product customization to their needs, among others.
Volume-Based Pricing
Volume-based pricing offers customers incentives or discounts based on the volume of consumption or usage. This model rewards customers for buying in bulk or increasing their usage to take advantage of better pricing. This consumption-based pricing model is popular in cloud storage, telecommunications, and software.
Dropbox, for example, offers volume-based pricing for its cloud storage services. As customers increase their storage needs, they can upgrade to higher tiers that offer larger storage capacities at a discounted rate per unit. This pricing strategy persuades customers to store more data with Dropbox and gives them cost savings as their usage grows.
Volume-based pricing can benefit both customers and companies. Customers can enjoy cost savings while companies can incentivize larger purchases and enhance customer loyalty and retention with discounts.
Benefits of a Consumption-Based Pricing Model
By now, you may have gleaned some insights into how consumption-based pricing might be a win for your SaaS company, but let’s take a more in-depth look at the benefits for you and your customers.
Benefits for Your Company
I know you need to get buy-in from your board and/or the rest of your management team before making big pricing changes. Here are some key bullet points to review for your executive summary:
Increased Revenue and Business Growth
Every SaaS company wants to capture more value from customers with higher usage levels. You can do this by aligning pricing with actual usage. This inevitably leads to increased retention, revenue, and business growth over time.
Better Resource Allocation
Have you thought about ways you could allocate resources more efficiently? By understanding customer usage patterns, you can optimize resource allocation, ensure scalability, and avoid over-provisioning.
Improved Customer Insights
Everyone wishes they could read their customers' minds. Well, with data on customer usage patterns and preferences, you can gain deeper insights into customer behavior, identify upselling or cross-selling opportunities, and improve product development based on customer needs. When competition is fierce, having a leg up with insights will ensure you stay ahead of the curve.
Benefits for the Customer
Need to increase buy-in from sales and account management? I put together some memo points to help:
Cost Control and Flexibility
Customers appreciate the cost control and flexibility offered by a consumption-based pricing model. They only pay for the resources or features they actually use, allowing them to align their costs with their specific needs and budget.
Scalability and Agility
Scaling usage up or down as customer needs change is another advantageous benefit in an uncertain economy. Customers can quickly adjust their usage levels without being locked into fixed plans or commitments, providing them with agility and scalability.
Fair Pricing Based on Value
Customers perceive consumption-based pricing as fair since they are charged based on the value they receive. This alignment between price and value enhances customer satisfaction and fosters long-term relationships.
Implementation Considerations
I’ve put together the top considerations you should take into account for your SaaS business below.
Consideration #1: Does Your Product/Service Have Clear Usage Metrics
Having clear and measurable usage metrics that directly correlate with the value customers derive from your product or service is necessary to implement a consumption-based pricing model.
If your product or service doesn’t have clear usage metrics, a consumption-based pricing model may not be your best option. Without measurable usage indicators, it becomes challenging to determine the fair value customers derive from your offering and align pricing accordingly. In such cases, alternative pricing models like fixed subscription pricing or feature-based pricing may be more appropriate.
Consideration #2: Is it an Industry Standard?
Adopting a consumption pricing model can help you stay competitive and meet customer expectations if it is widely accepted in your industry. However, if consumption-based pricing is rare, then you should carefully assess its feasibility and survey your customers to see if it could be a fit.
Consideration #3: Do You Have (Or Can You Develop) the Capabilities to Use this Model?
First, you need to determine if you have the necessary infrastructure and capabilities to accurately measure, track, and bill based on usage. You should evaluate whether your systems, processes, and billing mechanisms can support this model effectively. If not, consider the cost-to-benefit ratio for developing these capabilities.
Evalue and Consider if Consumption-Based Pricing is Best for Your Organization
A consumption-based pricing model offers numerous benefits for both companies and customers alike. It aligns pricing with value, provides cost control and flexibility, and supports business growth.
However, implementing this model requires careful consideration of usage metrics, industry standards, market conditions, and the necessary capabilities.
By assessing these factors and understanding the specific needs of your SaaS company, you can determine if a consumption-based pricing model is the right choice to drive success and meet the evolving demands of your customers in today’s volatile market.
Are you considering making the switch to a consumption-based pricing model? We’d love to hear your questions or thoughts below.
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